A Strong Dollar Is Rubin's Legacy; It May Also Cure the
World's Ailing Economies

By

William Pesek Jr.

Updated Feb. 22, 1999 12:01 a.m. ET

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R obert Rubin has a unique way of leaving his mark on autograph seekers. At times, he pulls a crisp dollar from his wallet and retraces his own signature, the one stamped on all U.S. notes. The routine always gets a good laugh, but it's also an apt metaphor for his likely legacy as Treasury Secretary.

A strong dollar will likely be synonymous with the Rubin era. So impressive is this man's economic handiwork that even amid rumors that he will soon step down, the greenback continues to head higher. After months of ups and downs, investors again are loading up on dollars now that Europe and Japan have signaled that they support its rise against the euro and the yen. The idea is that a stronger greenback is necessary to boost the flagging economies of the two regions.

Expectations for a firmer dollar helped U.S. bond yields drift slightly lower, a dynamic that may continue. The 30-year Treasury ended the week at 5.39%, compared with 5.42% a week earlier.

Analysts generally think the dollar is headed above 125 yen in the near term, up from Friday's close of 121.10, and well above 110 yen just last month. The euro, meanwhile, fell to its lowest level yet last Friday, at $1.1080, and analysts think it will soon break below $1.10, down sharply from its peak of $1.18 shortly after the European currency was launched at the beginning of the year. Indeed, the movement of capital into dollar-denominated assets may halt the recent rise in Treasury yields, or at least slow it.

Europe and Japan are looking anew to exchange rates for help because the other levers of economic management have fallen short. Government spending efforts have failed Japan, and the 11 members of European Economic and Monetary Union are effectively barred from increasing government outlays. Interest-rate adjustments haven't done the trick either. Rates in Tokyo are practically zero, while the European Central Bank is too concerned about its credibility to let rates fall any lower.

So that leaves Japanese and European policy makers talking down their domestic currencies. In Germany and Japan, authorities are making no secret of their hopes for a weaker euro and yen. And Rubin's recent silence on foreign exchange levels has been read as tacit approval of a firmer dollar. It's no mystery that the U.S. needs a strong currency to curb inflation. We also need foreign capital to keep our interest rates low and our stocks up.

As Group of Seven officials prepared to gather in Bonn Saturday, indications were that similar strong-dollar comments would be in the air. Even if the G7 as an institution shies away from formal currency agreements, some informal accord may be needed to fix the world's economies. European growth is waning, as evidenced by Germany's reporting that economic growth in the fourth quarter fell 0.4%, the first quarterly decline since early 1995. This helps explain why the war between EMU member governments and the European Central Bank is intensifying. Against that backdrop, it should be no surprise that the euro continues to soften.

The slowdown in global growth may make a rate cut by the European Central bank inevitable in the months ahead. That expectation, coupled with highly public squabbles between Europe's new central bank and the Continent's left-leaning politicians, isn't giving investors much confidence. LIMresearch.com points out that on every Friday since its launch, the new currency has weakened against the dollar, by 0.7% on average. The euro has posted similar declines versus the British pound on Fridays. Are investors afraid to own euros over weekends? It sure seems that way.

The central bank scored big points with the markets by guiding its overnight call rate down to a record low of 0.08%. Then the Bank of Japan started buying up Japanese government bonds from the repurchase-agreement market. It also announced plans to issue Y600 billion of short-term financing bills, only the second such sale since November 1997. All told, these moves constitute "twist operations" meant to manipulate the yield curve by selling short-dated debt and buying long-term debt.

It's unclear whether Japan will continue to assault rising bond yields. Indeed, some observers wonder if Tokyo's actions amounted to a maneuver before the G7 meeting to head off criticism of Japan's market conditions. But the efforts have been successful so far. The benchmark 10-year Japanese government bond yield, which had surged above 2.40% early this month, sank to 1.76% Friday from 2.08% a week earlier.

One bright spot is that the Ministry of Finance is allowing its Trust Fund Bureau to resume purchasing Japanese government bonds; 200 billion yen of bonds in February, and the same amount in March.

But while Japan is taking steps in the right direction, the yen is likely to soften, both as a consequence of more accommodative monetary policy and as a catalyst for stronger export activity. "Until Japan gets its economy working again, the yen is a sell," says Michael Hartnett of Merrill Lynch.

By contrast, the dollar and the U.S. economy continue to flex their muscles. Construction of new homes rose 3.8% in January to a 12-year high. Also, the U.S. trade gap actually narrowed in December, to a deficit of $13.79 billion from $15 billion in the previous month. Analysts, who had predicted a widening of the gap, say the data underscore the vigor of the U.S. economy. And labor markets remain tight. The number of Americans applying for unemployment insurance, on the basis of a four-week moving average, is now at 292,000, the lowest since February 1989.

Inflation, however, isn't heating up. Consumer prices rose just 0.1% in January, putting the advance at a 1.7% annual rate. While producer prices jumped 0.5% last month, the 0.1% drop in the core rate, which excludes food and energy, encouraged investors that prices will remain tame. Productivity, meanwhile, is on the rise.

Federal Reserve Chairman Alan Greenspan is expected to walk a tightrope this week as he attempts to explain to Congress a seemingly endless expansion that seems to have lost touch with the basic laws of economics. But by the time he wraps up his semiannual Humphrey-Hawkins testimony, Greenspan likely will have made one point clear: The Fed is on hold.

Aside from signaling steady policy, Greenspan probably will avoid tipping his hand on the direction of short-term rates. Keeping his options open affords Greenspan the flexibility he needs to address any downside or upside risks that develop as the year unfolds. "Don't expect any bombshells," predicts Lawrence Kudlow of American Skandia.

Fed officials privately worry that the economy is growing too rapidly and that wealth created by the stock market will keep things going. Yet with international markets still fragile and U.S. productivity growing, the Fed is likely to remain tolerant. The firm dollar, global deflationary forces and more restrictive fiscal policy should also allow the Fed to be patient.

But here's where the consensus among Fed watchers breaks down. Kudlow argues that the lack of inflation pressures, the preponderance of global deflationary forces and the strong dollar will force the Fed to ease again this year. On the other side, Joseph Carson of Deutsche Bank thinks the Fed is underestimating the upside risks. "Strong output, fast money growth and tight labor markets aren't consistent with price stability," he warns.

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